Streetwise Professor

May 5, 2015

Blaming SRO Lapses on For-Profit Status: A Straw Man Dining on Red Herring

Filed under: Commodities,Derivatives,Economics,Regulation — The Professor @ 8:28 pm

The frenzy over the Sarao spoofing indictment has led to the CME Group receiving considerable criticism about the adequacy of its oversight of its markets and trading system. One argument that has been advanced is that the CME’s for-profit status (and the for-profit status of other exchanges) is incompatible with its role as a self-regulatory organization. A piece by Brooke Masters titled “Exchanges Need to Balance Policing and Profitability” in the FT a few days ago puts it this way:

The Sarao case highlights the potential problems with the current US system of relying on “self-regulatory organisations”, including the exchanges, to do much of the frontline policing of markets. They are supposed to make sure traders abide by the rules and refer serious misbehaviour on to government regulators.

This system may have worked when exchanges were owned by their members, but now that they have to generate profits for shareholders, conflicts have emerged. A market that cracks down too hard or too quickly could drive away paying customers. The CME controls the futures market allegedly used by Mr Sarao, but the temptation to go soft could be far greater in areas where trading venues compete.

This is a straw man dining on red herring. The for-profit status of exchanges has little, if anything, to do with the incentives of an exchange to self-regulate. Indeed, for some types of conduct, investor ownership and for-profit status likely improves exchange policing efforts substantially.

I addressed these issues 21 years ago, and then again 15 years ago, in articles published in the Journal of Law and Economics, and 22 years ago in a piece in the Journal of Legal Studies. In the older JLE article, titled “The Self-Regulation of Commodity Exchanges: The Case of Market Manipulation,” I demonstrated incentives are crucial, and for some types of conduct the incentives to police were weak even for non-profit exchanges.

Exchanges (which were organized as non-profits) historically made little effort to combat corners, despite their manifest distorting effects, because the biggest costs of manipulation fell on inframarginal demanders of exchange services (namely, hedgers) or third parties (people who do not trade rely on exchange prices when making decisions), but exchange volume and member profitability depended on the marginal demanders (e.g., speculators) who were little affected. Therefore, exchanges didn’t internalize the cost of corners, so didn’t try very hard to stop them. For-profit exchanges would have faced the same problem.

In other cases, exchanges-be they for profit or non-profit-face strong incentives to police harmful conduct. For instance, securities exchanges have an incentive to reduce insider trading that reduces liquidity and hence raises trading costs leading to lower trading volume. Again, this incentive is largely independent of whether the exchange is for-profit or not-for-profit.

Exchange incentives to police a particular type of deleterious conduct depend crucially on how the costs of that conduct are distributed, and how it affects trading volume and trading costs. The effect on volume and trading costs determines whether and by how much the exchange’s owners (be they shareholders or members) internalize the cost of this conduct. This internalization depends primarily on the type of conduct, not on how the exchange is organized or who owns it or whether the exchange can pay its owners dividends.

In fact, for-profit exchanges have stronger incentives to adopt efficient rules relating to certain kinds of conduct than member-owned, not-for-profit ones. In particular, the members of mutual exchanges were intermediaries; brokers and market makers mainly. The intermediaries’  interests often conflicted with those of exchange users. In particular, self-regulation on member-owned exchanges often took the form of adopting rules and polices that were explicitly intended to benefit their members by restricting competition between them, thereby hurting exchange customers. For instance, member owned exchanges operated commissions cartels for decades: Only forty years ago last Friday (“May Day”) was the NYSE commission cartel that dated from its earliest days dismantled by the SEC. Even after the commission cartels were eliminated, member-owned exchanges adopted other anti-competitive rules that benefited members. Self-regulation was in large part an exercise in cartel management.

Further, powerful members, be they big individual traders or important firms, could often intimidate exchange managers and enforcement personnel. In addition, daily interaction between members contributed to a culture in which screwing a buddy was beyond the pale, but in which many a blind eye was turned when a customer got screwed. Not all the time, but enough, as the FBI sting in ’88-’89 and its aftermath made clear.

So no, there was no Eden of mutual, non-profit exchanges that rigorously enforced rules against abusive trading that was despoiled by the intrusion of the profit-seeking snake. The profit motive was there all along: exchange members were obviously highly profit-driven. It just was manifested in different ways, and not necessarily better ways, than in the current for-profit world.

This also raise the question: just who would own, control, and manage a neo-mutual, non-profit exchange? Big banks, either directly or through their brokerage units? Does anyone think that would solve more problems than it would create? Does anyone honestly believe that there would be fewer conflicts of interest and less potential for abuse in such a setup?

This all gets back to the issue of why exchanges demutualized in the first place. It had zero, zip, nada to do with self-regulation and rule enforcement. It was driven by a seismic technological change. I showed in my 2000 JLE article that non-profit form and mutual ownership economized on transactions costs on floor based exchanges, but were unnecessary in an electronic marketplace. I therefore predicted that exchanges would demutualize and become investor-owned as they shifted from open outcry to electronic trading. That’s exactly what happened over the next several years.

In sum, exchange ownership and organizational form are not the primary or even major determinants of the adequacy of exchange self-policing efforts. The incentives to self-regulate are driven more by economic factors common to both for-profit and not-for-profit exchanges, and the choice of organizational form is driven by transactions cost economizing (including the mitigation of rent seeking) rather than by self-regulatory considerations.  The tension between policing and profit existed even in non-profit exchanges. So those who fret about the adequacy of self-regulation need to get over the idea that going back to the future by re-mutualizing would make a damn bit of difference. If only it were that easy.


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  1. Good piece prof.

    Not to mention that exchange surveillance staff probably have an excellent relationship with their counterparts at the local regulator.

    A compliance officer being pressured to drop an inquiry to keep volume wouldn’t even need to go up the internal food chain to object to this. He can just call exactly the right people at CFTC or whomever, and involve them. Little risk of career damage. Maybe even a benefit.

    So I highly doubt any such sales pressure can exist. For every spoofer, there are potentially many victims, all complaining to the exact same sales people. Piss those victims, and you keep the spoofer’s volume at the cost of losing theirs. It goes to whatever competing exchange offers a similar product in what they perceive as a cleaner environment.

    This is even more so in the era of the HFT. They could care less what the line they’re trading actually is. Oil, coffee, gilts, equities, who cares – as long as it’s a line, it’s liquid, it’s tradeable and it’s volatile (but not because it’s being spoofed), it’ll do.

    Comment by Green as Grass — May 6, 2015 @ 6:51 am

  2. Excellent post, Professor. Thank you for your work.

    Comment by WB — May 6, 2015 @ 8:05 am

  3. @WB & @Green-Thanks.

    The ProfessorComment by The Professor — May 6, 2015 @ 2:28 pm

  4. O/T but funny:

    A new Russian tank announced with much fanfare as superior to Western machines stalled during a dress rehearsal for Victory Day celebrations in Moscow on Thursday.

    The T-14 Armata, making only its second public appearance, ground to a halt on Red Square, opposite Vladimir Lenin’s mausoleum.
    Sergei Shoigu, Russia’s defence minster, was reportedly forced to approach the tank to find out what had happened; servicemen then tried to hook it up to another military vehicle and tow it away.

    Comment by Green as Grass — May 7, 2015 @ 10:17 am

  5. @Green-Hilarious. There is a Potemkin-esque feel to the T-14. Remember all the hoopla over the Russian stealth/5th gen fighter (PAK FA/T-50)? Now it is evident that the jet has huge problems. (Not that the US should gloat, given the F-35.) But I am getting the same feel with the T-14. More hype than reality. And of course, the issue is not whether they can build a few prototypes of a whiz-bang tank. The issue with the Russians is whether they can engage in serial production. I think that these projects are more about the opportunities to steal than they are about actually producing anything.

    The ProfessorComment by The Professor — May 7, 2015 @ 10:46 am

  6. Or maybe cargo cult? Look at what we built. It looks like a big scary tank. It must be a big scary tank!

    It’s definitely a combination of tractornomics, and / or of a camel being a horse designed by a committee.

    From 1945 till very recently, you have probably noticed that every Russian tank had that domed turret, designed to lower the profile and make incoming shells bounce off.

    Unfortunately, because of that shape, the tank’s own gun breech bounced off the ceiling of the turret if it tried to fire while depressed more than a degree or two. As a result, it could barely fire at all from hull down. In addition, the Soviet tendency to fit the BFG9000 out of Doom into all their tanks meant that inside the turret, there was room for the gun or the crew, but not both. So they fitted an autoloader instead, which as well as being slower than a crew, was also mechanically unreliable.

    The result was classic encounters like the Golan Heights, at which *two* Israeli Centurions were attacked by 150 Syrian T62s and defeated them, destroying 60 of them for no loss (

    Russian tanks have actually been getting worse in many respects. The T72 was a poor man’s T62, with less armour and an even slower autoloader.

    The T14 has already written the first glorious page of its operational history….

    Comment by Green as Grass — May 7, 2015 @ 12:09 pm

  7. @Green-Interesting. I also recall that the autoloader had a nasty tendency to load the gunner’s arm into the breech. The size of Russian tanks were also limited by the size of Russian railroad tunnels, and it looks like this tank is similarly size-constrained.

    So I guess we are both skeptical about Vlad’s new wonder weapon.

    The ProfessorComment by The Professor — May 7, 2015 @ 8:36 pm

  8. For profit status has been totally misread by critics of exchanges, and by regulators. Exchanges would not exist today if they were non-profit. I am not happy with a lot of decisions exchanges have made, but we’d be better off dismantling the government regulators and do nothing regulators like the NFA first.

    Comment by @pointsnfigures — May 11, 2015 @ 12:10 pm

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